The impact of IFRS 16 on financial services entities

SUITS THE C-SUITE By Aidell R. Gregorio

Business World (11/21/2016 – p.S1/4)

In previous articles, we discussed an overview of the new International Financial Reporting Standard (IFRS) 16, Leases, which will replace the current guidance, International Accounting Standard (IAS) 17.

IFRS 16 will significantly change the lease accounting practices of lessees since, instead of recognizing a periodic lease expense over the lease term for operating leases under IAS 17, lessees would now need to recognize most of their leases on their balance sheets. IFRS 16, however, does not change the way lessors classify and account for their leases.

IFRS 16 will have a significant impact on one specific industry sector — the financial services sector. Because banks usually have a network of branches in order to reach more clients, they enter into property lease commitments on the branch premises that they occupy. As such, IFRS 16 may have significant implications on the lessee-banks’ balance sheets and consequently, on their operations and even regulatory capital requirements.

LESSEE ACCOUNTING

IAS 17 previously required lessees, under operating leases, to recognize a periodic lease expense on a straight-line basis over the lease term. However, IFRS 16 now requires lessees at contract inception to recognize a right-of-use (ROU) asset and a liability to make lease payments, which are measured at the discounted value of the future lease payments.

Subsequently, lessees will recognize amortization expense on the ROU asset and interest expense on the lease liability. As the interest expense depends on the declining balance of the lease liability, total expenses arising from the lease contract will be higher during the initial years of the lease contract, similar to finance lease accounting under IAS 17.

IFRS 16, however, allows lessees to opt for a method similar to IAS 17 in accounting for their operating leases when the leases involved have a term of 12 months or less and do not contain a purchase option. Also, lessees may choose to retain accounting for leases similar to IAS 17 for leases in which the underlying asset is of low value. We should note, however, that IFRS 16 does not provide a quantitative threshold for assets to qualify as “low-value.” This means that lessees will have to make their own judgment on the assessment using the application guidance under the new standard.

THE IMPACT ON BANKS’ CAPITAL AND OPERATIONS

For branch premises, most banks enter into long-term operating lease commitments which are currently not recognized on their balance sheets. Under IFRS 16, such off-balance sheet lease commitments will result in a significant increase in the total assets and total liabilities of these banks.

This may have an impact on the capital adequacy ratio (CAR) required for banks. Under the current regulatory landscape, the Bangko Sentral ng Pilipinas (BSP) requires that banks operating in the Philippines maintain a CAR, which should be adequate relative to the banks’ asset size. Since operating leases are not currently recognized on the balance sheet, there is no such regulatory requirement to hold capital against those leases. However, with IFRS 16, the ROU asset will increase the gross assets of banks and may be included in determining their CAR level. As of now, the BSP has not yet issued any guidance on the impact of IFRS 16 on prudential reporting and CAR reporting purposes. Nevertheless, it would be sensible for banks to evaluate the possible effects of the new standard on their capital requirements should the BSP decide to include the ROU asset in computing for the CAR. For the time being, banks will need to diligently monitor any BSP issuances in response to this new standard.

Furthermore, some banks enter into sale-and-leaseback transactions to manage their capital requirements. Since all long-term leases will now have to be recognized on the balance sheet, such sale-and-leaseback transactions may no longer provide the lessee-banks with a source of off-balance sheet financing.

Moreover, banks should anticipate that IFRS 16 will also affect the way they do business with their customers, since the impact of IFRS 16 may extend to the banks’ borrowers, who may have significant operating lease commitments. The bulking up of the balance sheet translates to higher thresholds for these borrowers to be able to meet their debt covenants with their banks. As a result, borrowers may start to negotiate with their banks to allow them either to provide for more headroom on their covenants, or to retain the use of the current lease accounting in their covenant calculations.

For all these reasons, IFRS 16 (which becomes effective Jan. 1, 2019 with early adoption permitted) is likely to have significant implications on the financial statements, operations and capital requirements of banks. As this will have material impact on the balance sheet of banks and will generally result in a front-load recognition of their expenses, banks should perform a preliminary assessment of the impact on their current long-term lease commitments. This assessment will be more complex for geographically dispersed bank networks with more lease commitments and may require a longer time to prepare. That being the case, banks should, as early as now, ensure that they have the processes, systems and controls in place necessary to comply with the requirements of IFRS 16.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.

Aidell Amor R. Gregorio is a Senior Director of SGV &Co.